Why You Shouldn’t Use the Snowball Method to Pay Down Your Debt

December 16, 2016

If you are in debt, you might be happy where you’re at. However, there’s a good chance that you’ve come to despise your debt and have resolved to live debt free. In this case, there are a number of strategies to pay off your debt. You could just make minimum payments on all your debt. This would be the least painful in the short-term, but of course would mean staying in debt for longer. To pay off your debt faster, you need to pay extra on your debt. If you have multiple loans or forms of debt, you need to decide how to allocate extra payments.

Regardless of how you choose to tackle your debt, it is important that you don’t take any new debt on in the process! This means that if you’re currently in credit card debt, don’t keep using credit cards. Don’t finance a new car. And stick to a budget!

The ‘Snowball Method’ is One Popular Debt Repayment Strategy

Dave Ramsey and others recommend you use the ‘snowball method’ to pay down your debt. Basically, you arrange your debts from smallest to largest. Each month, you make minimum payments on all your debts except for your smallest debt. On the smallest debt, you make as large of a payment as you are able to. You continue to do this until the smallest debt is paid off, at which point you move to your second smallest. As you pay off debts, the extra amount you are paying toward the next smallest debt progressively grows. Your debt repayments ‘snowball’ as you continuously roll your prior debt payments into your extra payment.

The Snowball Method is Psychologically Motivating

Psychologically, using the snowball method is great. You start off with a relatively easy challenge, and reach a ‘win’ fairly quickly. As you rack up successive wins, you gain the financial ‘muscle’ to slug through the progressively larger loans. The snowball method also quickly reduces the number of debt payments you need to make each month. Regardless of the individual payment amounts, the simple fact of having several payments to make each month can be a drag and a hassle.

The Snowball Method is Mathematically Inefficient

Mathematically, however, the snowball method can be extremely inefficient. The snowball method does not take into account the interest rates of any of your debt. If your credit card bill is your smallest debt, you plow all your extra cash into that debt. But if your car loan is your smallest debt, that is the first target. Your credit card bill likely has close to a 20% interest rate, while your car loan is probably closer to 5% interest. With the snowball method, you might be attacking your relatively innocuous car loan while your credit card debt is eating you alive!

A Mathematically Efficient Avalanche

The ‘avalanche method’ of attacking debt prioritizes debt pay-off by interest rate, rather than loan size. Approaching a debt by interest rate makes this method the quickest way of paying off debt. Of course, with the avalanche method, you might not have the psychological boost of having a ‘quick win’ at the beginning. You highest interest debt may be $20,000 worth of credit card debt, which could very well take several years to pay off. For some neat graphs illustrating this point, check out this ‘Debt Destruction Tool’.

Does It Really Matter?

So this might seem like a fun argument for personal finance nerds, but does it actually make that much of a difference whether somebody picks the snowball method or the avalanche method? Maybe. It really depends on the debt that you’re holding. Your higher interest debt might happen to be among your smaller debt. In this case, the avalanche method and snowball methods would yield similar results.

How do the strategies compare in Ramsey’s example?

In Dave Ramsey’s argument for the snowball method, he provides a list of debts as an example. It just so happens that in his example, you would pay your high interest credit cards first, regardless of whether you use the snowball or avalanche method.

Credit card 1: $500 at 13% with a monthly payment of $25.
Credit card 2: $1,000 at 19% with a monthly payment of $50.
Car loan: $6,000 at 4% over four years with a monthly payment of $135.
Student loan: $15,000 at 5% over 10 years with a monthly payment of $159.

Thanks to this calculator, we don’t have to pore over spreadsheets of data to compare the results of the avalanche and snowball methods. In his example, Dave Ramsey assumes that you can make the minimum payments plus $100. This would make our debt payoff budget 469.

With the snowball method, you’d be debt free in 52 months, having paid $2665 in interest. With the avalanche method, you’d be debt free in 52 months, but having only paid $2599 in interest. In this example, the two methods only yield a $66 dollar difference in interest. Here the method you choose really doesn’t matter.

What about a different set of debts?

But what if that second credit card had a balance of $15,000? Sound extreme? It’s not. The average credit card debt is over $16,000. If this were the case, the avalanche and snowball methods would have you paying off your debts in a very different order. But lets look at the numbers again.

So now our hypothetical debt is:

Credit card 1: $500 at 13% with a monthly payment of $25.
Credit card 2: $15,500 at 19% with a monthly payment of $395.
Car loan: $6,000 at 4% over four years with a monthly payment of $135.
Student loan: $15,000 at 5% over 10 years with a monthly payment of $159.

We’ll stick with Ramsey’s original assumption that you can afford to make all the minimum payments and have $100 extra each month to throw at your debt. This makes our debt payoff budget $814.

This time with the snowball method you’d be debt free in 58 months, having paid $11550 in interest. With the avalanche method, you’d be debt free in 55 months, having paid $9196 in interest. Now the different is $2,354. Significant? You decide.

A Successful Snowball is Still Better Than a Failed Avalanche

Despite the mathematical benefits of the avalanche method, the snowball method still has the psychological benefits of building momentum. Those initial quick wins may be necessary to psych you up for the slog of paying off your debt. If you know that you’re likely to get discouraged tackling a larger loan right off the bat, you’re better off sticking with the snowball method than failing with the avalanche method. Or perhaps you can combine the two methods first knock out a smaller debt, then move to your debt with the highest interest rate.

Lower Interest Rates Means a Faster Snowball or Avalanche

Regardless of which repayment strategy you choose, lower interest rates will speed up the process. Many people assume that their interest rates are all set in stone, which is not the case. There are several ways to lower interest rates on one or more of your debts. Lower interest rates mean that more of your payments are going towards paying off your debt rather than paying interest.

Directly re-negotiating interest rates

One way to lower your interest rates is by directly calling your credit card company and just asking for a lower rate. Why would a credit card company give you a lower rate? Simply to keep you from going to the competition. They’re always worried that you’ll transfer your balance to a competitor that’s offering you a better deal. They may say no. They may offer to roll your balance into a loan with lower interest. Or they may simply lower your rate. While you’re at it, also ask to have any annual fees removed.

Before you jump at an offer, however, make sure you know the details. If they are offering to roll your balance into a loan with a fixed payment plan, be sure that you’re allowed to make extra payments on the loan without incurring a penalty. And if they are offering a lower interest rate, be sure that they aren’t tacking on an annual fee in return.

Transferring balances

While you may be stuck paying off a credit card balance, the balance is not stuck in its current account. Credit card balances can be transferred from one card to another. Transferring a large balance to a credit card with a lower interest rate or a 0% intro rate could potentially save you a significant amount on interest.

Once again, however, don’t just focus on the lower interest rates. Be on the lookout for fees. Transferring to a card with an annual fee (or a higher annual fee) in return for a lower interest rate could still end up costing you more. Some cards also charge a balance transfer fee which would also offset some or all of your interest savings. For more deals, NerdWallet has a good post diving in to the nitty-gritty of balance transfers.

Snowball vs. Avalanche Might Be a False Dilemma

We’ve dug into the snowball vs. avalanche argument, yet in many cases, snowball vs. avalanche is a false dilemma. The snowball and avalanche methods both assume that you need to keep all your debts separate. What if you could roll up all your debt into a single payment? And what if you also saved money on interest and sped up your repayment? Sound too good to be true? It’s not. This is known as consolidating your debt, and can be a great option for paying off your debt.

Be careful with debt consolidation

Some debt consolidation ‘services’ prey on people who are struggling with their debt, but don’t actually help with your debt. They offer the convenience of a single payment. Often this payment is still lower than your current payments. However, their new payment plan either is loaded with fees, has a higher interest rate, or both. The only way they are able to offer you a lower payment is by stretching out the repayment period. Which is exactly opposite of what you want.

Not all debt consolidation services are bad

While there are definitely predatory consolidation services, there are also consolidation services that can work for you. Non-profit credit counselors can be a great resource, especially if you feel overwhelmed by your debt situation. Non-profit credit counselors offer similar consolidation and repayment plans as for-profit services. However, since these counselors are acting in your best interest, they are more likely to offer you a repayment plan that actually saves you money and speeds up your debt repayment. However, even with non-profit credit counselors, do your homework on the plans they are offering to ensure that they are your best option.

Do your own debt consolidation

Instead of working with a service that consolidates your debt for you, you might be better off doing your own debt consolidation. To do this, you simply take out a low-interest loan equal to the balance of your other debts. You then use the cash from your new loan to immediately pay off your other debts.

Of course, this depends on you having access to low-interest loans, which is a lot easier said than done. If you have stellar credit, you might be able to secure a personal loan with an interest rate low enough (~10%) to at least pay off any credit cards, although you would likely still want to keep lower interest debt by itself. One good place to look might be P2P lending sites such as Prosper.

If you are a home owner, your options are better since you can use your home as collateral against an extra loan. When banks have something to use collateral, they give you a much lower rate. Your best options in this case are either to refinance your current mortgage to give you the extra cash necessary, or to take out a home equity loan (also known as a second mortgage). You could use a home equity line of credit (HELOC) as well, but I’m uncomfortable with HELOCs not having locked interest rates. I also don’t like that HELOCs always give you quick access to more debt.

Pick a Plan and Run With It

Deciding on a debt payoff strategy can definitely make a difference in how fast you pay off your debt and how much interest you end up paying. However, more important than anything is to actually start tackling your debt. So pick a strategy that you think will work for you and run with it. If the snowball method or avalanche method makes sense to you, use it! If you feel that you’d benefit from the structure of credit counseling, or other professional financial advice, work with people who are looking out for your best interest and who share the same passion for eliminating debt. And if you do your own debt consolidation, try to do so in a way that will allow you and encourage you to pay off your debt as quickly as possible! And most of all, always look forward to the freedom that being debt free will bring!

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While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.

Comments

You definitely added a nice wrinkle with the debt consolidation angle. I think people definitely get too focused on the various accounts of debt and don’t take into consideration that there are other options out there to reduce the interest paid on the debt. Thanks for the great reminder!!!

Really well said. I personally used the debt snowball method religiously when I was paying off debt, but switched midway because I saw the math and knew I was so committed that I would not fall off the wagon. Great stuff!